Credit Markets: Finding the Weakest Links

Jacinto Torres, an associate director of S&P Rating Services, contributed to this report.

Who are the "weakest links" in the global debt market? At Standard & Poor's Ratings Services, we use the term to describe those companies, governments, or other debt-issuing entities rated B- or lower, with either a negative outlook from S&P or with ratings on CreditWatch with negative implications, and therefore most vulnerable to default. S&P updates this list monthly.

Negative outlooks and CreditWatch listings serve as good leading indicators of actual downgrades. The proportion of defaulters from the portfolios of the weakest links in the U.S. going back to 1999 in any one- or three-year period is higher than the proportion of defaulters from the entire pool of speculative-grade (issues rated below BBB-). The one-year default rate for weakest links, on average, was 6.6 times higher than for all issuers with speculative-grade ratings since 1999, and was 11 times higher at the end of 2007, when the U.S. speculative-grade default rate was at a 25-year low.

Global weakest links continue to increase sharply, as eroding credit quality leads to lower ratings and more entities with negative outlook or CreditWatch. As of Oct. 15 global weakest links increased for the eighth consecutive month, to 181 (see the full list), with combined rated debt worth over $388 billion.
Recession Is to Blame

The continued increase in weakest links is not surprising given the volatility in the credit markets and the unfolding recessionary conditions in the U.S. In the 2001 recession the sharp rise in defaults accompanied the rise in weakest links. In 2008, 54 of the 61 publicly rated companies that have defaulted through Oct. 15 were weakest links.

Since our September 2008 report, nine entities were removed from the list and 28 were added, for a net addition of 19 issuers. The final issuer added to the list was Uno Restaurant Holdings, which was upgraded to CCC from D following its decision to pay its Aug. 15 interest payment before the 30-day cure period expired.

Of the 28 additions to this month's list, 17 were from the U.S., seven from emerging markets, three from Europe, and one from Canada. The media and entertainment sector had the biggest increase in weakest links, with seven entities, followed by forest products and building materials with three.

The sector breakout of weakest links has consistently identified the media and entertainment, consumer products, forest products and building materials, and retail/restaurants sectors as most vulnerable to default. The media and entertainment sector showed the highest vulnerability to default, with 40 weakest links, constituting 22% of the total number of weakest links. This is followed by consumer products with 19 weakest links, and forest products and building materials and retail and restaurants sectors with 18 weakest links each. Entities in these sectors are particularly vulnerable to cyclical trends in the macroeconomic environment. Moreover, increased domestic and global competition has pressured these companies to adopt more aggressive financial policies, leading to some of the highest volumes of leveraged activity in the past several years.

Geographically, U.S.-based issuers (including those in tax havens such as Bermuda and the Cayman Islands) are featured disproportionately on the weakest links list, accounting for 77.3%. This preponderance is partially attributed to the higher ratings penetration in the U.S. marketplace (see table 5). By volume, the 140 U.S.-based weakest links account for $346.30 billion of debt, or almost 90% of the total $388.52 billion of debt issued by all weakest links. Much of the dollar amount of the U.S. portion of the debt is attributable to giant automakers Ford Motor (F) and General Motors (GM), both of which are rated B-, with ratings on CreditWatch with negative implications.

Why American Savers Have Drawn the Short Straw

American savers, take a bow. This is your moment of vindication. Your hour of glory. And you earned it (in a manner of speaking).

You resisted the siren call of plastic teaser APRs, dutifully living within your means to store money for a rainy day. You never took out an interest-only mortgage. Never had to pawn the copper pipes from your exurban McMansion to pay the reset on your liar loan. Your credit score would have gotten you into Harvard at age 12.

Good for you! Your reward: injurious savings yields, inflationary rot, and election-season neglect, all served up with a dollop of institutional insecurity.

Even with a current account deficit that, starved of domestic savings, requires $2 billion a day in foreign financing, economic policymakers are fixated on propping up credit and giving the participants in the housing bubble second chances. In order to do so, they are stripping the hides off of net savers.

Since August of last year, the Federal Reserve has slashed interest rates from 5.25% to 2.00%—wielding a blunt instrument that was swung enough to bend the yield curve in favor of suffering banks. You know, the institutions that screwed up but were too big and important to be deprived of an inalienable right to cheap deposits that they can loan out at several points higher.

Indeed, a year ago, a six-month certificate of deposit earned, on average, 3.53%, according to Bankrate.com (RATE). Today, that's down to 2.03%. A one-year CD that earned 3.75% at this point in 2007 was offered for as little as 1.92% in April, before inching up to its present 2.38%. It's hardly a secret that banks are only able to pay out such pittances thanks to depositors' knee-jerk desire for security: "Hey, I might be earning crumbs on my cash, but at least I'm not losing money."

Sure you are. Wholesale inflation has soared 9.8% in the past 12 months, the highest clip since 1981. The more widely cited consumer price index jumped to 5.6%. In other words, while your saved buck was adding 2 cents or so on one end (and even less after taxes), three times as much was getting singed off the other end of that dollar bill. "Inflation is just deadly to savings," says David Gitlitz, chief economist at TrendMacrolytics, an investment adviser. Gitlitz observes that, taking into account the hit from inflation, rates haven't been this negative since the dreary 1970s. (That, in turn, gave way to an early '80s that saw the worst inflation in U.S. history since the Civil War.) "It steals your purchasing power and sets less and less of an incentive to keep money in the bank."

You're telling me. My trusty Manhattan pizza guy recently hiked the cost of a slice for the second time in the past year, from $2 to $2.50 to $3. "Why you mad?" he blurted, pounding a ball of dough. "Prices are nuts; you can't even buy a glass of milk no more." ("We're paying 128% more for a bag of flour," added his grandson-apprentice, with startling accuracy.) Even my barber justified taking up the cost of a standard trim and buzz by 20%. "Fuel surcharge," he deadpanned in his Uzbeki accent. (As it turns out, he rides the subway.)

In a perfect world, the Fed's rate-cutting campaign would have shored up real estate and the stock market. Instead, investors have been running for inflationary cover in hard assets like crude oil, gold, and even fertilizer. Oil, we all know, went from $70 to more than $140 in one year flat, sending gasoline and utility costs soaring and counteracting the lift from monetary and fiscal stimulus. Still comforted by that 2% savings yield? (Your mattress and piggy bank are in stitches.)

Commodity inflation has also been exacerbated by concurrent weakness in the dollar, which is stuck between a Europe that is loath to cut interest rates and a Washington that is too scared to hike them. Even with its recent rally, the greenback is only worth two-thirds of a euro. You practically have to wheelbarrow dollars to places like Madrid and Berlin.

All of which might be tolerable to the lonely and beleaguered saver if he weren't taunted daily by lopsidedly pro-spending, pro-creditor news stories. Forget about moral hazard. Forget about rewarding profligacy. Washington is hell bent on putting a floor beneath the housing market. And subtlety got vetoed out of the process. Consider some recent news reports:

"President Bush Signs $300 Billion Housing Rescue Bill" (AP)—increasing to $625,500 from $417,000 the size of home loans in high-cost areas that Fannie Mae (FNM) and Freddie Mac (FRE) are allowed to buy.

The number of Chapter 7 filings—designed to give individual debtors a "fresh start" by discharging many of their debts—recently rose by 36%.

"The FDIC may lower mortgage rates for delinquent IndyMac borrowers after suspending foreclosures..." (Bloomberg).

Maybe savers' ultimate vindication will arrive when and if every asset is so deflated, credit is so choked off, and misery is so prevalent that only those with cold hard cash can lob in lowball offers for homes, cars, and everything else. Assuming, of course, they didn't stash all their money in one of the many banks that is about to go under; the feds are closely watching 117 of them—and counting. The phone lines have never been so jammed with nervous clients.

Oh, the joys of saving.

The Labor Market's Cruel Summer

Financial markets were expecting the U.S. economy to shed jobs in the August employment report, released Sept. 5, but a big jump in the U.S. unemployment rate took Wall Street by surprise. The weaker-than-expected data for August suggest the U.S. economy is headed for recession and puts pressure on the Federal Reserve to lower rates rather than raise them, as the Fed has indicated it wants to do.

The unemployment rate jumped 0.4 percentage points to 6.1% in August, as nonfarm payrolls fell another 84,000, compared with an upwardly revised decline of 60,000 in July. Even worse for the labor market, June's 51,000 decline was revised to –100,000, for a net –58,000 revision over the prior two months. The drop in payrolls wasn't too far off economists' consensus estimate of 71,000, but the spike in the unemployment rate was another matter: The consensus estimate had called for it to remain at 5.7% (it was at 5.0% in April).

Manufacturing lost 61,000 jobs in August (44,700 in transportation equipment). Construction fell 8,000. Services employment fell 27,000, with a 61,600 drop in administrative and support services. The government added only 17,000. Household employment declined 342,000, while the civilian labor force rose 250,000.

Pressure for a Rate Cut
"The data are worse than expected across nearly every category and will likely add to the angst in stocks, weaken the dollar, but should give further support to Treasuries," wrote Action Economics analysts in a Sept. 5 Web site posting.

"The data are more confirmation that this is a recession," wrote S&P Economics in a Sept. 5 note.

The rise in the unemployment rate was entirely in adults, as the teenage rate dropped sharply as teens returned to school. Average hourly earnings rose 7¢ (0.4%), a slight acceleration from the recent 0.3% trend, and are up 3.6% from a year earlier, compared with 3.4% in July.

"The wage acceleration, although slight, could also cause some nervousness at the Fed," says S&P Economics.

Financial markets showed a relatively sharp response to the payrolls dive and jobless jump on Sept. 5. Treasury prices headed higher, with bond yields already at five-month lows following the rout in stocks this week. Stock index futures, meanwhile, headed lower. The dollar initially slid lower vs. other major currencies.

What does the market see ahead on the Fed policy front? Fed funds futures, a vehicle for market pros to make bets on future loan interest rate moves, extended their gains after the worse-than-expected employment report, and are now tilted toward another potential rate cut later in the year. "That's a far cry from the 75 [basis points] in tightening that had been suggested two months ago," notes Action Economics. At this point, it's unlikely the Fed will cut rates again, as policymakers have made it quite clear that they don't plan to take the funds rate below the current 2%.

Oil at $80 a Barrel?

In recent years, energy traders plus an active hurricane season have usually meant one thing for oil: higher prices. Yet with the departure of Hurricane Gustav, a rally for the embattled greenback is overshadowing new storm systems churning away in the Atlantic and showing how the prospect of a choppy U.S. economy is scaring traders far more these days than turbulent weather.

The price of a barrel of the benchmark West Texas Intermediate crude for October delivery dropped nearly $6 on Sept. 2, to settle at $109.71 on the New York Mercantile Exchange (CME). That's the lowest level since early April, and a slide of $37.56 since the record of $147.27 on July 11.

While Gustav appears to have delivered only a glancing blow to oil and gas assets in the Gulf of Mexico, the influence of Mother Nature has waned among traders and investors. The souring U.S. and global economies, alongside a strengthening dollar, are weighing heavily on oil prices, analysts say. In fact, the oil "demand destruction" implied by weak U.S. economic growth currently dwarfs both weather and geopolitical worries in determining oil's price. "If you can't rally with a hurricane up your nose—and 2 million barrels of refining capacity and 96% of your offshore supply under threat—it's hard to see what will cause a rally," says Peter Beutel, a veteran analyst with the energy risk management firm Cameron Hanover.

Back to Reality
Oil prices have slid so far and so fast that the retreat has led analysts to predict further puncturing of what they call a speculative bubble. Many analysts don't see a floor at $100, but rather at levels as low as $70 or $80. "This is start of a fall to $80 crude by the end of the year, maybe as early as September," says Joel Fingerman, principal of FundamentalAnalytics.com, a Chicago-based energy consulting firm.

"Oil prices are dropping because they are inflated," says Fadel Gheit, senior energy analyst for Oppenheimer (OPY). "You cannot sustain an artificial price forever. At the end of the day supply-demand fundamentals will take over."

Oil traders and some analysts have been blaming high oil prices on rising demand from developing economies, but now troubles in the U.S. economy are spreading across the globe. "A few months ago it was all about Chinese demand," says Stephen Schork, an energy consultant in Villanova, Pa., and editor of The Schork Report, a daily energy newsletter. "But a lot of the strength [in oil's price] was hype and hot air."

In addition to a gloomy economic environment and lower demand, a strengthening dollar is also behind oil's recent drop. Since July 15, the dollar has gained 8.5% against the euro. "The rise in the dollar is the best explanation of oil's drop," says Beutel.

Airline Stocks Ascend
While energy companies' stock prices fell on Sept. 2, airline stocks jumped at the prospect of cheaper fuel. Northwest Airlines (NWA) gained 13%, to $11.07. UAL (UAUA), the parent of United Airlines, was up 9.5%, to $12.16, and AMR (AMR), American Airlines' parent, jumped 8.7%, to $11.23. In 2008, airline shares have traded inversely to crude.

Despite the drop in crude prices, the market remains volatile. That's why some analysts say the market could again cede ground on supply and demand, resuming a trek upward. Earlier this year, several investment banks made headlines with reports forecasting a "super-spike" for crude, based on producers' inability to keep pace with soaring demand from China and the Middle East. Goldman Sachs (GS) energy strategist Arjun Murti was among those in that camp; he predicted $200 per barrel in coming months.

Indeed, crude prices could recover if the dollar weakens again or if oil-producing countries trim their output to keep prices high, as some analysts have speculated. OPEC is scheduled to meet on Sept. 9 in Vienna and has indicated it may defend a price of $100 per barrel.

Hanna on the Way
There is also ample meteorological uncertainty. On Tuesday, Tropical Storm Hanna was predicted to come ashore in Georgia and South Carolina late in the week and could regain hurricane strength later in the day. Tropical Storm Ike formed late Monday in the Atlantic Ocean and may become a hurricane in the next day or two as it approaches the Bahamas. Meanwhile, Tropical Storm Josephine formed in the eastern Atlantic, and the National Hurricane Center said it could near hurricane force as it moves west.

The verdict? The only certainty in the oil market remains volatility. "I have no idea where oil prices are going from here," says Gheit. "Go ask Goldman Sachs."

Can Women Bridge the Retirement Savings Gap?

Many studies have shown that women lag behind men in saving for retirement. In a 2008 survey of more than 1,300 workers or retirees over age 25 by nonpartisan Employee Benefit Research Institute (EBRI) and Matthew Greenwald & Associates, 68% of women and 76% of men said that they "had" saved for retirement; 59% of women and 70% of men said they were currently saving; and 58% of women and 64% of men said they were contributing to a workplace retirement account. Two recent studies of participants in large-company plans show similar results. Vanguard, a mutual fund company that also manages retirement plans, reported that in 2007 the average account balance of more than three million participants in their 401(k) plans was $56,723 for women, compared with $95,447 for men. More recently, Hewitt Associates consultants surveyed nearly 2 million participants in large-company 401(k) plans the company manages and found that women had an average of $56,320 in their accounts, compared with over $100,000 for men.

The savings gap is expected to persist for the next 40 years or so, projects EBRI researcher Jack VanDerhei. Although he assumes more workers will have retirement accounts because of new rules encouraging automatic enrollment, boosting the dollar amounts of savings for both men and women, there would still be a sizable gender gap. For example, a 25-year-old woman currently in a 401(k), starting to save now, would save an estimated $255,000 in current dollars by age 65; while a man of the same age would accumulate savings of $325,000. For workers who are 55 now, the amount he projects they would accumulate in their account between now (to add to previous savings) and when they retire at 65 would be $29,452 for men and for women, about a third less, $20,506.

There are plenty of measurables, documented reasons for women's lower retirement savings. Women spend less time in the labor force, often because of care-giving demands, and/or are more likely to work part-time at some point. They earn about 80 cents on the dollar compared with men. And they're less likely to participate in some type of pension plan. The fact that, on average, women tend to live three years longer than men and live alone for more years intensifies the effects of the savings gap, making it even more crucial for them to prepare better for their golden years.
Save Early, Save Often

As far as I know, no one has come up with a fool-proof retirement savings strategy for women that's any different from the best strategies for men. Start saving as soon as you begin working, and design and follow a realistic budget that allows you to join your employer's retirement plan. Contribute as much as you can to your company plan or—if one is not available—to an IRA. And don't take money out of retirement savings to meet short-term needs. These basics apply to everyone.

Beyond the basic budgeting, advisers recommend measures such as: Use calculators such as these from the Savings Education Council to estimate both your retirement needs and income based on current savings; use Social Security calculators to estimate how much Social Security you would receive based on your own earnings or as a spouse or widow; for married women out of the workforce, start a spousal IRA. If you have a life partner, you should both follow this advice, and also do a thorough analysis of your 401(k) and other investments, at least once or twice a year, rebalancing your portfolio if it's no longer well diversified.

It's worth pointing out that the gender savings gap is not just an issue for very low-earning women. Linda E. Katz, a financial planner in Huntington, N.Y., says she sees the same problem for women in middle management. Some of them, especially those who live in high-income areas, simply don't make enough money to save much. She also says that she sees quite a few clients who allow financial demands from their children and parents to trump putting away money for their own retirement.

Executives and professional women also need to pay more attention to their future, says Margaret K. O'Meara, a financial planner in Red Bank, N.J. For the high-income women she counsels, "the biggest things are the lifestyle and longevity issues," she says. Her clients may make $250,000 or $300,000 a year and still be behind on retirement saving. One of her clients in her 40s in this income range wants to leave her high-stress job to retire or downsize to part-time work, but she doesn't want to sacrifice the family vacation home or luxuries such as expensive wines and food to save for what could be as much as 40 or 50 years in retirement. Some women also lose a chance to catch up on saving by refusing to charge their college-graduate children for rent, cable TV, or other amenities.

The gender gap in retirement savings should concern all of us. A good resource is the nonprofit Women's Institute for a Secure Retirement, which contains a wealth of basic information about the barriers and potential solutions to the special retirement savings challenges that most women will confront at some time in their lives.

Manufacturing: Where's the Slowdown?

The U.S. factory sector appears to have weathered the summer months in better shape than economists had expected, based on a report on orders for durable manufactured goods for July released Aug. 27.

Orders rose 1.3% in July, matching the increase seen in June. The July jump was much better than the 0.1% increase expected by economists. Strength was widespread, with solid gains in defense, transportation equipment, primary metals, and computers and electronic products shipments.

"The gains extended a general overperformance of these measures since March despite an ongoing assumption that business investment will eventually cooperate with the recession scenario," wrote Action Economics analysts on Aug. 27.

The July rise came in spite of a 25.7% drop in defense orders (after a 1.50% June increase). Civilian aircraft orders rebounded 28.0% after dropping 21.3% in June. Aircraft orders have continued to defy fears that soaring energy prices would cap new orders and prompt sizable cancellations, which have yet to materialize.
"Stronger Than Expected"

Orders for nondefense capital goods excluding aircraft, the key indicator for capital spending, rose 2.6% after a 1.3% June increase. Durable shipments, a more stable indicator than orders, jumped 2.5% in July after a 0.9% June rise. Inventories increased 0.8%, which left the inventory-to-sales ratio at 1.54 from a revised 1.56 in June.

"The data are much stronger than expected for manufacturing, probably showing continued strong export demand," says S&P senior economist Beth Ann Bovino.

"The resilience of capital goods spending in face of tight credit conditions, a poor growth outlook, and declining business confidence continues to surprise," wrote Lehman Brothers (LEH) economist Zach Pandl in an Aug. 27 note. "In our view, relatively healthy growth abroad and the competitive value of the dollar are driving demand for U.S.-made capital goods.… If correct, the recent downturn in growth abroad and stabilization in the dollar could put pressure on capital goods spending in the months ahead."

"Manufacturing continues to do remarkably well given the weakness in the labor market and stresses in the financial system, and it likely continues to benefit from overseas growth," wrote John Ryding, an economist for RDQ Economics. "However, this does not indicate strength in the overall economy, and we do not see the Fed hiking rates in the second half of the year."

The Economy's Upside Surprise

For the U.S. economy, the surprises keep coming. One day after the release of a report that showed an unexpected surge in orders for durable manufactured goods in July , another government report showed a much larger-than-expected jump in second-quarter gross domestic product. But economists aren't ready to start uncorking the champagne just yet: Another report released on Aug. 28 showed that first-time filings for unemployment insurance fell in the week ended Aug. 23—but remain at levels consistent with a weakening labor market.

U.S. real (inflation-adjusted) GDP growth was revised upward, to a 3.3% annual rate, in the second quarter, from the 1.9% preliminary figure released in July. The market had expected a revision to 2.7%. Net exports added a staggering $85.4 billion to growth in the second quarter (or 3.1%), compared with $66.8 billion (2.4%) in the first. The revision to inventories shows them subtracting $39.2 billion from GDP, vs. the $52 billion figure reported previously.

Real spending was boosted to a 1.7% clip from 1.5% previously. Gross private investment was revised to -12.0% from -14.8%.

Housing Still in the Basement
Second-quarter government spending was revised up to a solid 3.9% growth clip, vs. 3.4% previously, while equipment and software spending contracted at a 3.2% rate. There was a surprisingly robust 13.7% growth pace for nonresidential construction. Residential construction continued its downward spiral, though at a diminished rate of 15.7% following quarterly rates of decline of 20%-27% in each of the prior three quarters.

Meanwhile, the chain price index, the GDP report's inflation gauge, was revised up to a 1.2% clip, vs. 1.1% previously. Excluding food and energy prices, the index was steady at 2.1%.

"The growth data are even better than many expected and again counter beliefs the economy was in recession in the first half of the year," wrote Action Economics analysts in an Aug. 28 Web site posting. Action left its forecast for third-quarter GDP growth of 2.0% unchanged.

"[T]he momentum going into the third quarter is clearly greater and could result in a significant upward revision to 2008 real growth estimates," says Standard & Poor's senior economist Beth Ann Bovino.

Worries Linger
But some economists were less sanguine. "[W]e think it is too soon to turn optimistic as the economy faces important challenges in the months ahead. Most important, weak consumer fundamentals will likely begin to assert themselves in the second half of the year as the stimulus from the income tax rebates begins to fade," wrote Lehman Brothers (LEH) economist Zach Pandl in an Aug. 28 note.

John Ryding, an economist for RDQ Economics, wrote in an Aug. 28 note that "the income side of the economy has expanded by only 0.3% over the last year in real terms, while expenditure-based real GDP is up 2.2%. Moreover, the income estimate of GDP fell in both the fourth quarter of last year and the first quarter of this year—looking much more like a classic recession that we think began in December 2007."

The higher-than-expected GDP figure was tempered somewhat by the initial claims data. Initial claims for unemployment insurance dropped 10,000 in the week ended Aug. 23, to 425,000. The drop was in line with market expectations of 430,000, as claims were expected to decline after spiking in the wake of the extension of unemployment benefits. Still, the weekly figure has remained above 400,000, suggesting continued labor market weakness.

"It may be the still-lofty level of claims as we approach the end of August that should be of greater concern to the markets, given the risks to the economy from an elevated price level that may still be rippling through consumers' spending decisions and business fixed investment," wrote Action Economics analysts.